QUARTERLY ECONOMIC POLICY STATEMENT OF EESTI PANK
- Estonia's economic growth was 4-5 pp above the potential in the second quarter of 2006. The growth was driven by very strong domestic demand, which, in turn, relies on the credit boom financed from abroad and a rapid income growth. However, the stronger-than-expected economic expansion may lead to a steep economic slowdown in the coming years.
- The continuous disharmony between productivity and wage growth constitutes a threat to Estonia's competitiveness. Private consumption soared in the second quarter, exceeding GDP growth.
- The annual consumer price growth was higher than expected in the second quarter and there are signs that core inflation is picking up speed.
- Exports growth, though still strong, has somewhat slowed down. The share of oil in exports was remarkable.
- The credit growth rate has slightly slowed, but loan volumes are still considerable and mainly directed towards the real estate sector.
- A surplus must be a clearly defined budgetary policy objective.
- As it is unlikely Estonia will adopt the euro in 2008, it is even more important now to pursue prudent economic policy targeted to economic balance.
Global economy continued rapid growth, European interest rates are on the rise
From the point of view of the past two decades, the first half-year global economic growth was one of the fastest: the annual growth of both GDP and industrial production amounted to 4-5 per cent. The US Federal Reserve decided to keep the key interest rates unchanged, as economic slowdown should reduce inflationary pressures.
The second-quarter euro-area economic growth (2.4 per cent) was the fastest of the past six years. This, combined with the inflation rate above 2 per cent, led the European Central Bank (ECB) to continue raising interest rates. The ECB key interest rate is now 3 per cent. Estonia's main trading partners, Finland and Sweden, displayed outstanding results - their second-quarter GDP growth was 6.6 and 5.5 per cent, respectively.
Economic expansion is maintaining its pace
According to the preliminary estimates of the Statistical Office of Estonia, the second-quarter economic growth was 12 per cent, which means the upward cycle is developing at the same pace. The fast growth was mainly based on domestic demand, i.e., consumption and investment. This is proved by the exceptionally rapid growth in the construction sector, the increase in the trade deficit, and the retail sales growth figures. Consumption expenditure may even have picked up speed, whereas investment apparently grew hand-in-hand with GDP.
Core inflation is showing signs of quickeninggrowth
The annual consumer price growth was higher than expected in the second quarter as well as in July, when it constituted 4.5 per cent. Inflation was 5 per cent in August, but price growth is expected to slow in September. Although the contribution of motor fuel to inflation has not diminished, Eesti Pank still observed that core inflation (the consumer basket without food, alcohol, tobacco, and fuels) was picking up speed.
The main reason behind the soaring price increases was the unexpectedly high rise in housing costs - building materials, renting, and repair services underwent the steepest price growth. Food prices have also been rising faster than expected (3.5 per cent in the second quarter), being more and more in line with the changes taking place in the euro area.
Continuous rapid growth of income and consumption
In the second quarter, private consumption rocketed and exceeded GDP growth. Income growth was still rapid: wage growth amounted to 15 per cent, and the number of employed went up by 6.7 per cent. According to estimates, the average pension had increased by approximately 27 per cent by the end of the second quarter.
Retailers' annual sales turnover growth rate, which formed almost 25 per cent in the second quarter, refers to active private consumption.
Investment is based on bank loans
Similar to the first quarter, lively investment activity continued and the share of investment and stocks in GDP was approximately 32 per cent. The private sector accounts for the majority of investments, and these are mainly financed by external funds. Investment, for the most part financed by bank loans, is primarily made in construction, real estate development and other domestic-market oriented branches, which makes Estonia's economy even more dependent on the developments in global financial markets.
Employment reached the highest level in 12 years
Strong employment growth continued in the second quarter of 2006: the number of employed amounted to 650,000, which is the highest level of the past 12 years. The employment growth rate was 6.7 per cent, which means 41,000 new employees were added. Demand for labour force increased the most in domestic-demand-oriented fields (construction, trade). The problem of unemployment is being replaced by that of labour shortage.
Wage growth outpaced productivity for the second quarter in row. This may pose a threat to the exporting sector competitiveness, especially in light of the deceleration of both exports growth and employment growth in the manufacturing sector.
The fact that employment in the manufacturing sector is declining might reflect changes in the structure of business activity - more labour-intensive operations are outsourced from countries with lower labour costs.
Exports growth (excluding oil) has slowed
The second quarter displayed a fast growth in the exports of goods (approximately 29 per cent), with oil and reprocessed oil products playing a significant role. With oil products left aside, Estonia's exports growth has decelerated to around 13 per cent.
External balance continued to deteriorate: the four-quarter average decreased by 0.4-0.5 pp of GDP, which means the current account improvement has reverted.
Credit growth has slightly slowed, but volumes are still extensive
As expected, the interest rates on long-term loans granted to the non-financial sector have been following the dynamics of the six-month Euribor. The interest rates on housing loans increased gradually in the second quarter, amounting to 4.2 per cent in July. Thus, interest rates have risen by a percentage point year-on-year. Although the loan growth indicator has somewhat dropped, credit growth is still rapid (over 50 per cent year-on-year). The absolute volume of loans issued is also considerable (in the second quarter approximately 19 billion kroons, i.e., around 40 per cent of the quarterly GDP).
The stock of household loans and leasing increased by 7.8 billion kroons in the second quarter. As expected, housing loans, which soared by 6 billion kroons quarter-on-quarter, made up the great bulk of the annual growth of loans and leasing. Despite the continuous strong demand for housing loans, the number of objects on sale has increased, sales periods lengthened, and price growth slowed. In recent years there has occurred a gap between the price of a square metre of real estate and the average monthly wages, which has persisted, indicating that real estate may be overpriced in some market segments.
The growth of other loans resulted mainly from the increase of consumer credit. The annual growth of consumer credit soared to 102 per cent, although its volume is still rather small.
Revenue collection has been successful
The faster-than-expected economic growth led to a rapid growth of government income, whereas tax revenues exceeded the forecast. As at the end of July, the state budget had already received 61 per cent of the planned revenue. Budgetary revenue surpassed expenditure by 3 billion kroons.
The government is going to adopt a supplementary budget for 2006, which is going to increase expenditure. Provided that the consolidated budget surplus will still exceed 2 per cent of GDP, our fiscal policy can be considered rather conservative. Thus, budgetary surplus serves as a strong base for economic balance. If Estonia's economy continues to expand faster than considered sustainable, the next years' objective will have to be not budgetary balance but a surplus of at least 2 per cent of GDP.
Estonia's first half-year economic developments show that our economy has been growing faster than expected. This is a rapid inflationary growth, which continues at an impracticable speed and is triggered by extremely strong domestic demand. The latter is based on external credit and very fast wage growth. Thus no decline in domestic demand can be expected in 2007.
Eesti Pank's decision to raise the risk weighting of housing loans, which took effect on 1 March, has resulted in an increase of banks' capital. However, it has not considerably hindered credit activity. Therefore, Eesti Pank decided to increase the reserve ratio of commercial banks to 15 per cent as of 1 September. The efficiency of this measure can be estimated at the end of this year.
Despite the measures taken by the government and Eesti Pank, and the raising of interest rates by the ECB, Estonia's economic development has not yet taken a more balanced growth path. Rapid credit growth is persisting, the current account deficit is increasing, wage growth is outpacing productivity, and the exports of oil and oil products form a large share in our exports growth. Estonia's economic position calls for continuous vigilance.
As it is unlikely Estonia will adopt the euro in 2008, it is even more important now to pursue prudent economic policy targeted to economic balance.
With a view to establishing new capital adequacy requirements due to take effect as of 2007, Eesti Pank monitors closely credit market developments and associated risks. It is increasingly more important to keep pursuing even stricter fiscal policy. Taking into consideration Estonia's rapid economic growth, which is likely to continue in 2007, the next year's budgetary surplus should be at least equal to that of 2006, i.e., 2 per cent of GDP. If the Estonian economy maintains its high growth rate, a 2-per-cent surplus should be the objective in the coming years as well.